Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.

U.S. interest rates today are clearly low and below historical long-term averages. Recalling the double-digit rates of the 1970s and early 1980s, I still find it somewhat astonishing that the yields on a broadly diversified basket of high-quality bonds (whether Treasury, corporate, or municipal securities) are often now below 2% or 3%. Given the rise in prices for food, health care, and other select goods and services, such an environment can rightfully be thought of as “financial repression.”

Interestingly, the evidence tells us that investors aren’t shying away from bonds. Quite the opposite. And I guess it’s hard to blame them: With the stock market subject to nerve-wracking volatility, bonds have seemed like a comparatively safe harbor in recent years. Since 2000, the broad U.S. bond market has produced a cumulative net return of 8.1%, versus 2.4% for the broad U.S. stock market.*

But with current bond yields low, interest rates lower, and the economic outlook cloudy at best, Vanguard doesn’t think future bond returns will be nearly as robust as they’ve been. In fact, looking forward, we’re inclined to expect significantly elevated levels of volatility in the bond market.

So, what should investors do?

Well, while I can’t give financial advice on this blog, I certainly don’t mind repeating Vanguard’s time-tested philosophy that the simplest course of action—making sure you’ve got the right asset allocation based on your investment time frame, financial goals, and tolerance for bearing the risks that go along with bonds and all other investments—may be the most strategically effective.

If you’re comfortable with your current allocation to bonds (and I’ll offer some food for thought on that topic below), you might be well advised to do nothing at all. But if the bond market’s recent run has caused your bond allocation to surge beyond your preferred target, it may be a good time to rebalance back toward equities. (You can get some helpful asset allocation guidance by taking the interactive Investor Questionnaire on vanguard.com.)

Tactical considerations for bond investors: Three schools of thought

These days, the airwaves seem filled with market commentators offering one of three popular suggestions for bond investors. All three groups urge investors to alter their investment strategy in this low-rate environment.

The first group suggests bond investors take on more interest-rate risk in an effort to earn more income today, say, by moving your assets from a short-maturity bond fund to a longer-maturity bond fund. The second group suggests investors do the exact opposite and reduce interest rate risk, say, by moving assets out of one’s bond portfolio into a savings vehicle in an attempt to sidestep a future rise in interest rates. Obviously, both groups of investors are trading with each other. Which group “wins” will ultimately depend on the future path of interest rates (more on this in a moment).

Like the first group, a third group of market commentators suggests taking on more risk, but of a different sort. They point to the U.S. investment experience of the late 1940s and early 1950s—the last time U.S. interest rates were this low—as a rationale for moving strategically out of low-yielding conservative bond portfolios and into traditionally more-volatile assets, namely stock funds.

The benefit of hindsight tells us that stocks clearly outperformed bonds during the 1950s and 1960s. Looking at the charts below, interest rates during that period gradually tended to rise, while bond returns struggled to keep pace with inflation. Some observers think that U.S. history will repeat in similar fashion given some similarities today with the 1950s, namely near-0% short-term interest rates and high government debt levels.

So what are Vanguard’s thoughts on the idea of shifting out of high-quality bonds and into stocks?

Again, I can’t give advice here, but I would like to follow up on several previous blog posts and suggest that you keep in mind at least four things when trying to assess your portfolio.

1. Low interest rates imply low future bond returns.

We as investors first need to recalibrate our expectations for future bond returns. Unfortunately, the most direct implication of this low-rate environment is that bond portfolio returns are likely to be fairly puny going forward. As I wrote in March (“Why I still own Treasuries“), arguably the single best predictor of the future return on a bond portfolio is its current yield to maturity, or coupon. For the math Ph.D.s out there, this is because interest rates tend to follow a “random walk,” to use a phrase that originated with mathematicians studying fluctuating patterns in nature but which has become popularly associated with Wall Street thanks to the work of former Vanguard board member Burton Malkiel (more on this later).

For many bond mutual funds, this could imply a possible return over the next several years in the 2-3% range, an investment outlook we discussed at the beginning of the year*. Such muted returns, if realized, would clearly pale in comparison to the returns of the U.S. bond bull market that began in the mid-1980s. Yet another reason to keep the management costs of your bond portfolio razor-thin.

* IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Results may vary with each use and over time.

2. Be wary of blind devotion to “mean reversion.”

Vanguard continues to counsel investors that low yields and likely-low bonds returns do not, in themselves, dictate that future interest rates have to rise. Recall the hypothesis that interest rate movements are difficult to predict in large part because they tend to persist at their current levels? Well, that implies that U.S. interest rates—while low today—need not mechanically revert to their long-term average.

And the bond market’s views can change (often radically), as evidenced by the decline in U.S. Treasury yields thus far in 2012 despite many experts claiming that rates had to rise. Experts predicting a U.S. bond apocalypse this year were wrong (yet again), a testament to those fixed income investors who have stuck to their long-term strategy in this low-rate environment.

3. Be wary of “cherry-picking” history.

We all have to be careful of placing too much confidence in our own ability to predict the future. While the low-rate environment in the U.S. during the late 1940s and 1950s slowly and ultimately gave way to higher levels of interest rates and inflation during the 1970s, investors should also contemplate the recent situation in Japan.

As the charts below clearly illustrate, interest rates in Japan have remained extremely low (near 0%, in fact) for more than a decade and have yet to rise (or “mean revert”—that is, to move toward an average value over time) despite repeated predictions from some that they would. Since the early 1990s, it has been bonds that have provided Japanese balanced portfolios with the greatest (and in fact only) source of return. I would say bond buyers should be mindful of this history as well.

4. Treat the future with the humility it deserves.

Today, Vanguard continues to counsel investors to not only have lower, more reasonable expectations for future bond returns given today’s slim bond yields, but also reminds investors that a rising-rate environment is certainly not guaranteed, and that it may occur at a slower pace than some proclaim. To be sure, the relative long-run return outlook of stocks versus bonds remains formative, but Japan’s recent struggles underscores why any such formative outlook is not guaranteed.

So while Vanguard would assign low odds that the U.S. stock market over the next ten years will experience another “lost decade,” we believe that such an outcome shouldn’t be dismissed entirely. And even assigning a small probability to a Japan-like outcome can often lead one back to a broadly diversified stock/bond portfolio.

That is perhaps the best history lesson of all.

I would like to thank several of my colleagues for helpful comments and assistance, including (in alphabetical order): Fran Kinniry, Andrew Patterson, and Joanne Yoon in Vanguard’s Investment Strategy Group and Kyle Ashinhurst in Vanguard’s Retail Investor Group.

* Vanguard data for the period December 31, 1999 through June 30, 2012. For bonds, we used the Spliced Barclays US Aggregate Float Adjusted Index. For stocks, we used the Spliced Total Stock Market Index. Additional benchmark performance data »

Notes:

• All investments are subject to risk, including the possible loss of principal. Investments in bonds and bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market.

• The Vanguard Capital Markets Model (VCMM) is a proprietary financial simulation tool developed and maintained by Vanguard’s Investment Strategy Group and the Investment Counseling & Research group. The VCMM uses a statistical analysis of historical data for interest rates, inflation, and other risk factors for global equities, fixed income, and commodity markets to generate forward-looking distributions of expected long-term returns. The asset-return distributions shown in this paper are drawn from 10,000 VCMM simulations based on market data and other information available as of November 30, 2011.

• The VCMM is grounded in the empirical view that the returns of various asset classes reflect the compensation investors receive for bearing different types of systematic risk (or beta). Using a long span of historical monthly data, the VCMM estimates a dynamic statistical relationship among global risk factors and asset returns. Based on these calculations, the model uses regression-based Monte Carlo simulation methods to project relationships in the future. By explicitly accounting for important initial market conditions when generating its return distributions, the VCMM framework departs fundamentally from more basic Monte Carlo simulation techniques found in certain financial software.

• The primary value of the VCMM is in its application to analyzing potential client portfolios. VCMM asset-class forecasts—comprising distributions of expected returns, volatilities, and correlations—are key to the evaluation of potential downside risks, various risk–return trade-offs, and diversification benefits of various asset classes. Although central tendencies are generated in any return distribution, Vanguard stresses that focusing on the full range of potential outcomes for the assets considered, such as the data presented in this paper, is the most effective way to use VCMM output.

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Joe Davis

Joe Davis, Ph.D., is Vanguard's chief economist and head of Vanguard Investment Strategy Group, whose research team is responsible for helping to oversee Vanguard's investment methodologies and asset allocation strategies for both institutional and individual investors.
In addition, Joe is a member of the senior portfolio management team for Vanguard Fixed Income Group, which oversees more than $500 billion in assets under management. Joe frequently presents at various investment forums and has published studies on a variety of macroeconomic and investment topics in leading academic journals.
Joe earned his Ph.D. in macroeconomics and finance at Duke University.

Comments

Anonymous | August 6, 2012 7:01 pm

I’ve been completely confounded with the TIPS market. A year ago or so Mr. Davis stated he felt they were fully valued. 8 months ago the chief economist for Blackrock wrote an article “TIPSY investing”(which they took down from their website after 2 weeks or so). They Federal Reserve has a paper that seems to suggest they are dangerous because of an extreme illiquidity–with only the “on the run” issues having trading volume. I can see people with legacy wealth or countries holding the bonds or notes(they have the luxury of holding them to term as insurance). The average “Joe” and “Jane” would be much safer just buying 5K each in I bonds per year, if they feel compelled lock in 0%+ inflation, no? To me Vanguard is sending a mixed message they were said to be fully valued. Have they gained 15% or so since? Just a couple months ago with the new fund manager they stated every investor should have TIPS exposure and the Vanguard fund would be a good way. Now Vanguard is registering for a short term TIPS fund due to the volitility or danger of the big funds duration. What am I missing?

Anonymous | August 6, 2012 3:51 pm

Anonymous | August 6, 2012 12:21 pm

As a long term investor in VG heavily oriented toward equities, I have missed the bond boom of the last few years but still feel that I have been well treated by equities in the long term. Equities still seem to me to be the place to be going forward. As a retiree, I want to have “safe” investments to support me for about 4 years. Much of the excess over that will stay with equities until a more “normal” interest rate environment develops.
I echo several other responders in asking Joe’s view on REITs at this time. Traditionally wisdom says maybe 10% of a diversified portfolio but I wondering if they don’t deserve more, given rather stable, good performance over quite a few years. writers o

Anonymous | August 6, 2012 1:17 am

Anonymous | August 5, 2012 7:05 pm

Guys,
Don’t spend your valuable time guessing the trajectory of interest rates. I am currently researching Municipal bonds, the types that are secured and general obligation bonds. If you buy them in the state you live in, you end up not paying state and federal taxes and in some instances local taxes. The benefits depend on your tax bracket. If you use a laddered approach maturing in two, three, four & five years and so you can protect yourself if rates eventually rise. I am currently 30 % invested in ETF. I think mutual finds compared to ETF are far more expensive.Always remember the effect of compounding, every dollar that goes into investment rather than the fund company means more money in your pocket. Great Blog.

Anonymous | August 5, 2012 12:52 pm

Anonymous | August 5, 2012 12:42 pm

for the last 4 years atleast i have heard guests on cnbc warning of inflation and rates about to go up. sometime someone will be right and experts will be 50-50
on rates going up when it happens. the variables influencing the market are more than ever as the world is so unstable and greedy cheating is happeniing and trying to invest for the future is bleak.

Anonymous | August 5, 2012 11:09 am

Thanks Joe, for a well written piece. It has obviously ‘hit a nerve’ for many and perhaps refocused some thinking regarding asset allocations. I always enjoy reading the Vanguard blog.

Personally, I think you are correct in that if one is comfortable with their asset allocation and it fits their time line, there is little to do except remain vigilant, rebalance as needed, and keep learning what works (for yourself).

Predicting the next interest rate move and trying to ‘time’ a rebalancing never works. I am 70 and have tried almost everything over the past 30 years. For the past 7 years I have been 60 Equities, 38 Bonds and 2 Cash (rebalanced every January) and am up 23% after taking 2%/year as income.

Also, as far as I can tell, none of us bloggers work in the industry, so I think some of the replies are a little like the apprentice giving advice to the journeyman. I started investing at 5 figures with Vanguard 30 years ago and now have 7….IMO, nothing works like success.

Anonymous | August 5, 2012 9:51 am

SO,,really just what are you saying about High Yield Corporates {VWEHX] ?????
IF interest rates drop what happens to the NAV ???? Surely interest rates will probably drop to 4 or 5 % on high yields SO ???????

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At Vanguard, we’ve always believed in candid, direct communication with investors. In fact, it’s one of our core principles. In 2009, we created the Vanguard Blog so that we could talk about what’s happening in our industry and in the economy—and hear what’s on the minds of investors like you. More

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in Creation Unit aggregations. Instead, investors must buy or sell Vanguard ETF Shares in the secondary market with the assistance of a stockbroker. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.

Stocks of companies in emerging markets are generally more risky than stocks of companies in developed countries.

An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.

All investing is subject to risk, including possible loss of principal.